Externalities are important sources of market failure in the delivery of health services. This project will analyze in detail the externalities generated by antibiotics. Extensive evidence suggests that increases in antibiotic use can lead to increases in the prevalence of infections caused by resistant strains of bacteria, and that non-consumers of antibiotics share the risk of acquiring such infections. Resistant infections lead to greater morbidity, mortality, and costs of treatment. Catastrophe might follow epidemic outbreak of multiply-resistant, highly virulent strains unresponsive to available antibiotics. This project will model the spread of infection and resistance as a time-varying Markov process, whose transition probabilities are stochastic functions of prior antibiotic use and state occupancies. Estimates of parameters will be obtained by applying recently developed statistical techniques to a unique set of data. Measures of the costs associated with changes in risk will be examined and applied to find the social cost of marginal changes in antibiotic use. The results can be used to evaluate the welfare loss associated with the externality in the hospital, to compare possible national policies toward the control of antibiotics, and to analyze optimal hospital strategies for resistance control.